Q: How can I structure funding from friends and family in a way that is attractive to angel investors and venture capitalists?
CEO and founder
A: Some VCs like to see familial skin in the game, on the premise that you will work hard to keep your nearest and dearest from ending up under a bridge. A clumsily structured seed round, however, can alienate both the amateurs who love you and the professionals who, you hope, will someday love you.
So when Aunt Gladys starts fumbling in her carpetbag for a checkbook, talk her gently out of an equity stake. Instead, structure the investment as convertible debt: a loan that gets swapped for equity in the next big round of financing, says David Cohen, a venture capital investor and CEO of TechStars, a Boulder, Colorado-based angel fund. Convertible debt is attractive because you don't have to set a valuation as you do with equity. Overvaluing the company risks diluting your family's shares in the next round. If your loved ones make an investment based on a company valuation of $5 million, "it's not a fun dynamic when professional investors come along later on and tell them it's only worth $1.5 million," says Cohen. "Convertible debt defers that question to the people in the next round."
Because we all love our Aunt Gladyses, entrepreneurs often offer convertible debt holders the opportunity to swap the debt for equity at a discount. But excessive discounts can turn off VCs, says Jonathan Treiber, co-founder and CEO of RevTrax, a New York City-based company that helps retailers track which online ads lead to in-store purchases. Treiber offered his first rounders a 20 percent discount, which ruffled no feathers when he partnered with institutional investors two years later. But he says he knows other entrepreneurs who offered much larger discounts and met a lot of raised eyebrows when they sought additional funding.
Finally, avoid taking money from family members who might scare away future investors. Remember back in school, when you would do anything to prevent your friends from meeting your crazy brother? Now imagine him loose in the boardroom.